Small

Basic Analysis of Tariffs/NTBs

This simple model is designed to provide a consistent partial equilibrium framework for analyzing the effect of trade interventions under the assumption of perfect competition for a small economy. This is the setup used to start trade policy analysis in almost all textbook treatments. The sheet covers tariffs, export taxes, export subsidies, and import quotas. For analysis of tariffs and other interventions in general equilibrium see the HOS model with interventions (live or Solver version, which can also handle quotas). For partial equilibrium analysis of trade interventions with large countries see this model. For tariffs/quotas under monopoly see this model.

Consider an increase in a tariff (cell D26). As the tariff increases the domestic price is pushed up. As a consequence, producers respond by producing more, and consumers respond by consuming less. Hence, imports fall.

Now consider an export tax. An export tax will lower the domestic price. Producers respond by producing less, and consumers respond by consuming more. As a result, the volume of exports contracts.

Finally, consider an export subsidy. This will raise the domestic price relative to the world price. Consumers respond by consuming less, while producers produce more. The volume of exports will expand.

Welfare Effects of Price Interventions

Consider the impact of the tariff on the elements of total surplus. As the price rises, the producer surplus will increase, while consumer surplus will decrease. The tariff also generates revenue. Note that the total surplus declines, the difference between the total surplus with the tariff and with free trade is the deadweight loss.

An export subsidy has a very similar effect, except that the government will have to pay the subsidy, so the effect on revenue is negative. Again, the policy generates a deadweight loss.

An export tax will benefit consumers and hurt producers, and will generate revenue for the government. Once again, however, the losses exceed the gains, and so the policy introduces a deadweight loss.

Size of the Intervention and Deadweight Loss

Try increasing the size of any intervention while carefully tracking the total surplus. You will find that the total surplus begins to decline faster and faster. The reason is that the deadweight loss increases geometrically with the size of the intervention. The lesson is that large price interventions are much more damaging in efficiency terms than small ones.

Limits of Intervention

Try increasing the tariff above 175%. You will find that the price remains at 550. The reason is that a tariff of 175% raises the cost of importing to the autarky price, and imports cease. This type of tariff is called prohibitive. The welfare cost (deadweight loss) is the entire gains from trade. Any tariff higher than 175% taxes an activity that no longer exists, and can have no effect. The tariff is said to contain water.

A similar result holds for the export tax. Try a tax of greater than 46%. Exports will cease, and further increases in the tax have no effect. Price interventions that restrict trade have a natural limit where the trade is eliminated.

What about export subsidies? As you push the export subsidy up you will find that the domestic price just keeps rising. There is no obvious limit with price interventions that expand trade. With a high enough export subsidy it is possible that total surplus is pushed below autarky levels - a situation worse (in efficiency terms) than not trading at all.

Basic Effects of Quantitative Restrictions

Consider the import quota (cell D26). A quota works directly on the import volume rather than indirectly. As a result of restricting supply, the price is pushed up. In the default the quota volume is set at 350. This is not binding, because with free trade society wants to import this quantity anyway. As you lower the volume of allowable imports, the price rises. Consumers consume less, and producers produce more.

Welfare Effects of Quantitative Restrictions

As decrease the quota volume, consumer surplus falls while producer surplus rises. The quota also generates 'quota rent'. This arise because some people are able to import at the world price, and sell at the higher domestic price. This looks like tariff revenue, but it does not necessarily accrue to the government. It may accrue to various groups depending on how the right to import is allocated. It may even accrue to foreign producers...As with a tariff, the more restrictive the quota the higher the deadweight loss. Also like a tariff, there is a natural limit - a zero quota.

Tariff/Quota Equivalence

As you decrease the quota volume the domestic price rises. The difference between the domestic price and the world price (as a percentage) is called the tariff equivalent of the quota. Try setting the quota at a particular level, say 300. The tariff equivalent (reported in cell G26) is 25 percent. Take this value and enter it in cell D26 on the tariff sheet. What do we find? The volume of imports is 300. Not only that, but all the other values are the same too. This is called tariff/quota equivalence. The tariff and quota are the same except for the allocation of the rent. This result holds only under perfect competition.

Declining World Prices

Consider a situation where a binding quota is in place. Now decrease the world price (cell D24). What happens? Prices and quantities in the equilibrium do not change at all, but the deadweight loss (the difference between total surplus with the quota and with free trade) expands. Now try the same experiment with an initially equivalent tariff. The volume of imports rises, and the deadweight loss falls. Why the difference? With a tariff the domestic price is tied to the world price. When world producers get more efficient the domestic price must fall, and this improves welfare. On the other hand with a quota the volume of imports is fixed independent of the world price. When the world price falls this is reflected fully in an increased efficiency cost.